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Summary Article

The U.S. dollar recently appreciated relative to other currencies to its highest level since 2006.

That means if you travel overseas your dollar will be able to purchase more goods and services than it did six months ago.

A strengthening dollar also means prices for imports to the U.S. will be lower including for commodities such as oil. The drop in oil prices has been magnified by the appreciating dollar.

Falling import and commodity prices results in lower inflation. These are all positive developments for U.S. consumers.

On the other hand, a strengthening dollar means U.S. exports of goods and services are less competitively priced, which results in lower profits for multinational companies.

It also means potentially lower investment returns for U.S. investors who invest overseas.

What determines whether a currency appreciates or depreciates relative to another? What influences currency exchange rates?

There are four primary factors that influence the exchange rate between two nations:

1. Trade

Businesses trade by exporting and importing products and services. Foreign trade can be transacted in U.S. dollars, euros or many other currencies. Trade can be transacted in the home currency where the product is manufactured, in the currency of the product purchaser or in the currency of a third country that wasn’t even involved in the transaction.

A significant volume of currency exchange transactions arises from businesses that need to pay for a product in a foreign currency or to exchange a currency back into a domestic currency after making a foreign sale.

2. Investing

Institutions and individuals not only trade for foreign goods and services but they also invest in the capital markets of foreign countries. They do so by purchasing foreign assets, such as stocks, bonds and real estate.

To invest overseas, investors need to convert their home currency into the currency of the country where they desire to invest.

These capital account transactions result in a significant volume of currency exchange.

A nation’s ability to attract investment capital from foreign investors depends on its economic growth prospects, interest rates and inflation levels relative to other countries.

3. Government policy

Actions and the stated intentions by a nation’s central bank and federal government also influence the demand for its currency.

If a central bank is conducting monetary policy in a way that suggests interest rates will rise that will increase the demand for a nation’s currency.

If a country is being profligate in its spending, potentially stoking inflation that will weaken a nation’s currency.

4. Sentiment

While many currency exchange transactions are conducted in order facilitate trade and asset purchases, there is also a significant volume of currency exchange by speculators who are betting a particular currency will appreciate or depreciate relative to some other currency.

When the consensus is that a particular currency will appreciate, currency trades by speculators such as hedge funds can reinforce the strengthening trend for a time.

The Case of the Dollar

Which of these factors is driving the recent appreciation in the U.S. dollar?

The appreciation in the U.S. dollar appears to be less about trade and more due to global central bank policy, higher U.S. interest rates and accelerating U.S. economic growth relative to other nations.

The U.S. Federal Reserve recently concluded its quantitative easing program and has indicated it will begin raising short-term interest rates this year if the economy continues to improve.

Meanwhile, central banks in Europe and Japan have announced or are already undertaking quantitative easing programs and other measures to keep interest rates low as their economic growth has stagnated.

That means there has been a spike in demand for U.S. dollars by foreign investors because U.S. interest rates are significantly higher than rates in Europe and Japan.

The dollar strengthening trend has been reinforced by speculators, such as hedge funds, who are overwhelmingly positioned for continued appreciation in the dollar.

Such one-sided positioning by speculators often leads to a short-term reversal, but the underlying strength for the U.S. dollar appears to have some staying power given the higher level of U.S. interest rates and improving U.S. economic growth prospects.